Class Copy of ID Curve Analysis

8/8/2019 Class Copy of ID Curve Analysis

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Indifference Curves and

Utility Maximization


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Indifference Curves and Utility

Maximization

Marginal utility analysis is CardinalApproach, requires some numericalmeasure of utility in order todetermine the optimal consumption

combinations

Ordinal approach does not requirethat numbers but it arranges utilityin terms of preference.


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IC 1

IC 2

IC 3

A

B

Pizza

Movie

Indifference Curve Analysis

P P 1

M 1

M


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Consumer Preferences

Indifference curve shows allcombinations of goods that providethe consumer with the samesatisfaction, or the same utility

Thus, the consumer finds allcombinations on a curve equallypreferred

Since each of the alternative bundlesof goods yields the same level ofutility, the consumer is indifferentabout which combination is actually

consumed


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Indifference Curves

For a person to remain indifferent

among consumption combinations, theincrease in utility from eating morepizza must just offset the decrease inutility from watching fewer videos

Thus, along an indifference curve, thereis an inverse relationship between thequantity of one good consumed and the

quantity of another consumed indifference curves slope down


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Indifference Curves

Indifference curves are also convex to

the origin they are bowed inwardtoward the origin

The curve gets flatter as you move

down it

The marginal rate of substitution, orMRS, between pizza and videos

indicates the number of videos thatthe consumer is willing to give up toget one more pizza, while maintainingthe same level of total utility


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Marginal Rate of Substitution

The MRS measures the consumers

willingness to trade videos for pizza depends on the amount of each good theconsumer is consuming at the time

Mathematically, the MRS is equal to theabsolute value of the slope of theindifference curve

For example, in moving from combination ato combination b, the consumer is willing to

give up 4 videos to get 1 more pizza slopebetween these two points equals 4 MRS =4; from b to c, MRS = 1


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Properties of Indifference Curves

Because of the law of diminishingmarginal rate of substitution,indifference curves are bowed intoward the origin

Indifference curves do not intersect

Indifference curves are a graphicalrepresentation of a consumerstastes for the two goods


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Budget Line

Budget line depicts all possible

combinations of movies and pizzas,given prices and your budget

Suppose movies rent for Rs 4, pizzasells for Rs 8, and the budget is Rs40per week if you spend the entireRs40 on videos, consumer can

purchase 10 videos, and if on pizzasperson can afford 5 per week


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Units of pizza

Unitsofmo

vies

0

10

5

BudgetLine


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Summary

The indifference curve indicates

what the consumer is willing to buy

The budget line shows what theconsumer is able to buy

When the indifference curve andthe budget line are combined, we

find the quantities of each good theconsumer is both willing and ableto buy


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Choice: Combining Indifference Curves

with Production PossibilitiesHere, MRSx,y > Px/Py. The

individual can buy anadditional X for less thanthe additional unit isvalued.

Y/time

X/time

U3

U2

U1

Here, MRSx,y < Px/Py. Theindividual would have topay more than the

additional unit of X isvalued.

MRS x,y = Px/Py

x

Y

E


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Consumer Equilibrium

Thus,

MRS = Pp/ P

v

Further, the marginal rate ofsubstitution of pizzas for videorentals can be found from the

marginal utilities of pizza and video MRS = MUp/ MU

v


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Consumer Equilibrium

In fact, the absolute value of theslope of the indifference curveequals MU

p/MU

vand the slope of the

budget line equals pp/ p

v the

equilibrium condition for theindifference curve approach can bewritten as

V

V

P

P

P

MU

P

MU=

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Class Copy of ID Curve Analysis